In real estate, escrow is a term that crops up every now and then, but what exactly does it mean? While it’s certainly not exclusive to real estate, most of us will first encounter escrow while in the process of buying a home.

It’s useful to know what escrow in real estate actually is and why you will need it at some point. Having an understanding of how it works will also be a huge benefit when tackling the choppy waters of a real estate purchase. Read on to find out all you need to know.

What is an Escrow?

Put in the simplest terms, an escrow is basically an account held by a trusted, neutral third party. Within this account, documents or money are typically held until a set of predefined conditions are met. In real estate, this generally relates to ‘earnest money’ deposits, down payments, ‘clear title’ checks and property deeds — at least during the buying process.

There is another type of escrow you may come across in real estate, which relates to your lender. This will generally come into action once the house is bought and your mortgage payments have started. In this account, monthly payments covering tax and insurance will be stored throughout the year, before being paid off by your lender once the year is out.

How Do Escrows Work?

During the buying process, escrows work in a fairly straight-forward manner. You will go through the opening of the escrow process once you’ve committed to buying a certain property and have made an offer. Typically, you’ll make an earnest money deposit — a lump sum that makes up a small percentage of your down payment to show you’re serious about buying the property.

Rather than paying this directly to the seller — which can be risky as they may accept better offers in the meantime — you will pay this into an escrow account. With the escrow account open, the buyer and seller will come to a written agreement of the conditions that need to be met before the contents of the account can be distributed.

Next, they will continue to put their obligations into the account; for example the buyer may add any financing plus the down payment, while the seller will add documents proving a passed home inspection and clear title checks. Each escrow is different, and the terms are tailored to your own situation. Once all the conditions have been met, the trusted third party — or escrow agent — will double check, and if satisfied, will pass the money to the seller and the deeds to the buyer. This is known as the closing of escrow.

Regarding lender escrow accounts, your lender will generally take care of opening and maintaining it. In this account, insurance and tax payments that are typically paid annually are split into 12 monthly payments. Your lender will charge you this each month and the payments will be kept in an escrow account until the end of the year, when the bills must be paid.

Why Do I Need an Escrow?

By putting all payments and documents into a trusted escrow account, each party can be certain that their assets are secure. Escrow accounts remove the risk of any party — buyer, seller, lender or borrower — taking the money or deeds and running before all the relevant conditions are met. As real estate transactions are often among the most valuable most of us will make in our lifetimes, it’s essential that you know you’re protected.

Who Chooses the Escrow?

Choosing the escrow agent is the responsibility of both parties involved in the sale and purchase of real estate. Both the seller and buyer must come to an agreement as to who will be responsible for holding onto their respective assets until all the conditions are met. When using a real estate agent, they will typically suggest trusted escrow agents, who may be an attorney or title company, but the final decision is down to the buyer and seller.

When considering lender escrow accounts, you as the borrower are under no obligation to find and arrange an escrow agent. The lender will normally take care of this and will typically work with the same trusted agent for many transactions.

Escrows make a lot of sense once you understand how they work and how they can benefit you and secure your assets. It’s worth thoroughly researching escrow agents as there are many scammers out there who would be more than happy to ‘safeguard’ your finances. However, a good real estate agent will be able to steer you in the right direction.

With a passion for all things real estate and home design, Andra covers the impact of housing issues on our everyday lives. She writes about the financial implications of the new generations entering the housing market and about the challenges of homeownership. Andra can be reached at andra.hopulele@yardi.com